After having been hammered hard by a galloping inflation since 2005, many rightly worry about impact of the current devaluation on their purchasing power. On the other hand, those who send money to home (from abroad) and those in export sector, though may still worry about the potential for inflation, take the devaluation as a good news to get more Birr for each dollar they send home. In this short article, I will try to share my thoughts on what led to the current devaluation, its potential impact on people’s life and what measures could be taken to mitigate the potential adverse effects. I believe that the devaluation is a right policy measure. It addresses the serious problem that the country’s export sector, upon which the country’s potential for growth heavily relies on, faced due to the recent inflation. Though there are reasonable concerns about people’s life due to the potential effect of the devaluation on inflation, particularly consumers of imported goods, keeping the exchange rate low is not an appropriate policy to address it. First of all, except for certain commodities, the devaluation is unlikely to have a proportional effect on prices. Secondly, other policy options can be used to mitigate the inflationary impact of devaluation. Those options include monetary policies, fiscal policies, temporary subsidies for selected items (such as petroleum) and possibly salary adjustments.
The devaluation is a necessary outcome of the inflation that we saw over the past years. The fundamental determinant of exchange rates is the currencies’ values at home (how much goods and services one can buy with a unit of currency in the domestic market). Due to the inflation in Ethiopia over the past years, Birr’s value has significantly fallen within Ethiopia. Compared to the prices in 2001, Birr’s domestic value (the purchasing power of Birr in Ethiopia) has fallen by nearly a third. This is in contrast to the relatively stable prices in the big world economies. Figure A shows the Ethiopian and the US consumer price indexes (a weighted average of consumer goods in the two countries) from 2001 to 2010 (month of March). Compared to the price levels in 2001, the 2010 US price level has only increased by 23.5%, whereas in Ethiopia, it has increase by nearly 200% (prices tripled).
In the face of such high inflation, keeping a constant exchange rate will undermine the country’s economic growth. Exporters who face expensive prices at home but relatively stable prices abroad will find their profits squeezed. Keeping the exchange rate artificially low is like taxing the exporters. If the exchange rate was to be kept constant to its level in 2001, an exporter today (compared to an exporter in 2001) could have faced an equivalent of 65% SALES tax. This will adversely affect the country’s export both in the short and long run. In the short run, exportable items end up in domestic markets. In the long run, producers of export items (such as coffee farmers) may shift to non-exportable items, and those who intend to start establishing export companies will change their mind. With the export sector facing so much disincentive, the country’s growth would suffer a lot. So Birr’s devaluation is a reasonable policy to deal with the disincentive to exporters created by the inflation. And Birr has been devalued repeatedly in recent times. The question is whether devaluation is of enough magnitude. The graph below (Figure B) shows the exchange rates during 2001 to 2010 (for the month of March). The exchange rate increased to about 13.4 Birr/USD in 2010 from 8.4 Birr/USD in 2001. During March 2001 to March 2010, Birr had depreciated by about 60%. If the prices in the US and Ethiopia are good indicators of where the exchange rate should be, the exchange rate that leaves Ethiopian exporters with same level of earning for each product they export would be around 18.63 Birr/USD (=Exchage rate in 2001*(Price Level Eth in 2010)/(Price Level US 2010)). So the depreciation so far (excluding the most recent one) is far below what is needed to compensate the export sector. The new exchange rate (which is about 16.35), though not yet enough to fully compensate the exporters created by the inflation, is a huge incentive to the sector and close enough to what the price differences indicate.
Equally concerning issue about devaluation is its impact on inflation. Many Ethiopian consumers who haven’t seen equivalent amount of wage adjustments to face the turbulent inflation in recent years have lost so much of their purchasing power. A threat for a new wave of inflation due to devaluation will for sure be a source of major concern. Though that is a reasonable concern, keeping the exchange rate artificially low is not a proper solution. First of all, consumers haven’t got all the benefits from low exchange rate. A significant portion of the benefit actually went to the importers (who are already the better-off ones) rather than the average consumer. The artificially low exchange rate created foreign exchange shortage (by discouraging exporters and encouraging importers). And to address the shortage, banks have repeatedly used forex rationing. The rationing generated significant rent to importers. An importer whose turn is to get the forex is likely to have a monopoly power in the product market (since other importers cannot import the product). So even though the importer gets the forex at a cheap rate, he/she will sell the product at a much higher price. Instead of benefiting the consumers, the low exchange rate ends up generating higher profit for the importer (at the expense of the exporter whose profit is squeezed and consumers who pay high prices). Increasing the exchange rate, while providing access to every importer who is willing to buy at the ongoing exchange rate, can eradicate such rent for the importers without creating a proportionate increase in prices.
Though this argument applies to many of goods imported by private importers, there are important exceptions. One important exception is petroleum. Petroleum prices are administered by the government. Recently, subsidies on petroleum prices have been largely lifted. If the same policy is to be followed in the wake of the devaluation, the petroleum prices will observe a huge increase (almost proportional to the devaluation). One policy option could be subsiding the petroleum prices for a certain amount of period (with the aim of lifting them over time). This option applies also to other import items whose prices are administered by the government. Accommodating monetary (managing the money supply) and fiscal options (reducing government demand for imported goods) could also be combined with the subsidy for import items whose prices are adminstered by the government. If the inflation gets worse despite all these measures, adjusting salaries should be kept in the list of potential policy measures.
The contractionary monetary and fiscal policies to tackle the inflation could have a potential to slow growth. Providing subsidies and adjusting civil servants salaries to compensate for the inflation may, at least for a year or two, create pressure on the government’s budget. But those challenges are worth facing than maintaining a distortionary exchange rate that stifles the country’s export, creates inefficient rent for importers, and undermines the country’s growth.
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